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Funds: A dark, uncertain wilderness for investors

If you have been eager to add a hedge fund to your holdings, you should know that William Donaldson, the U.S. Securities and Exchange Commission chairman, recently called hedge funds "an accident waiting to happen."

While offering improved disclosure and useful risk reduction, many hedge funds are still in the wilderness because of questionable returns and high fees. Due diligence is needed to see how much a hedge fund will truly cost.

Some regulatory oversight will help. The SEC last year approved a rule requiring hedge funds to register as investment advisers by 2006. This would allow the commission to inspect the funds and require fund managers to adopt compliance controls.

But to more effectively keep tabs on the expanding $900 billion industry, which is projected to manage $2 trillion within three years, investors will still have to do the heavy lifting because of high fees and meager disclosure.

It has never been easy to get a clear picture of hedge fund returns. Several academic studies have noted that hedge fund index performance is inflated because indexes typically avoid including some things, like funds that have gone out of business.

In a study released late last year, Burton Malkiel, a Princeton University finance professor, reported that indexes might be overstated by 3.74 percent to 5 percent.

Aside from the burnished indexes, hedge fund returns are beginning to lag leading stock indexes. While money flowed into them last year, hedge funds averaged an 8.27 percent return, according to the Hennessee Hedge Fund Index, compared with 10.9 percent for the Standard & Poor's 500 index of large-company stocks.

Like most managed products, hedge funds will ultimately join the mediocrity dance called regressing to the mean, where most funds underperform or equal average industry returns over time. It is a statistical fact of investing.

Funds of hedge funds, or multimanager funds, which package several hedge funds, are especially tricky.If multimanager funds offered superior net returns, they would be a much easier pill to swallow for individual investors.

Yet funds of funds are among the costliest vehicles to own. In addition to underlying fund expenses of 1.5 percent to 2 percent annually plus management performance fees of 20 percent, multimanager funds overlay an additional layer of charges.

Marketers of these funds levy up to 3 percent annually for assembling the multifund products. It is tough to profit as an investor when you are 5 percent or more in the hole every year.

There is not much opportunity for the manager to generate alpha, or premium return above an index, because of the burden that fund expenses create, said Jim Hedges, president of LJH Global Investments in Naples, Florida, a hedge fund adviser.

Hedges said in a report on audits of 200 hedge funds with more than $250 million in assets each that fees were sometimes exorbitant, with management fees as high as 5 percent and performance charges up to 50 percent.

"These fees make hedge funds less competitive than traditional investments in many cases," Hedges said in his report.For hedge funds whose returns exceed their expenses, lower investment risk is a tangible benefit.

In research that will be published soon, Roger Ibbotson, the Yale University finance professor, hedge fund partner and chairman of the Chicago-based research firm bearing his name, will say that the risk from the hedge funds he surveyed is substantially lower than the S&P 500.

Including funds that had gone out of business and did not inflate their returns, Ibbotson found that the standard deviation, a common risk gauge, was 7.9 percent for the hedge funds he studied from 1995 through March 2004. The S&P 500's risk was 18.2 percent over the same period.

On the return side, though, the stinger was the high fund fees.

For diversification, multimanager hedge funds should not be the first stop. Consider low-cost index mutual funds that invest in real estate, energy stocks, commodities and inflation-protected Treasury securities as buffers to your stock and bond positions. Consider only multimanager funds with the highest after-expense returns.

Also, screen hedge funds by looking at their independent audits, ask how the funds are valued and whether the funds contain illiquid securities. This may shine some light on whether the fund is passing along unnecessary expenses and your ability to get your money out.

While not a completely transparent way of peering inside a hedge fund, audits shed some light on how much you are expected to pay for the privilege of investing.